In its latest 10-K, Lubrizol describes its primary business—lubricant additives (primarily for engine and driveline lubricants):

“We believe we are the market leader in lubricant additives, and we intend to remain the leader by continuing to invest in this business. Our Lubrizol Additives segment’s growth strategy is to continue to optimize our product mix while closely aligning production capacity with product demand. Challenging market forces and conditions continue to influence the Lubrizol Additives segment. A key factor is the low long-term global growth rate for this market, which we believe is in the range of approximately 1% to 2% per year.”

Pre-tax operating income in 2010 was $1B, on $5.4B in revenues—both records for the company. At an estimated purchase price of $9.7B (which assumes $0.7 net long-term debt), Berkshire is paying 10x pre-tax OI. And almost 4x shareholder equity.

Lubrizol’s gross profit percentage for 2010 was 33.1%, which also appears to be an all-time high. (2008 marked the five year low, at 22.3%; 2006 saw 24.6%.)

Lubrizol has earned very good returns on shareholder capital (excluding special items) in recent years. Its average return on shareholder equity for 2010 was 34.4%, also an all-time high.

I will not extend the theme, but the drift is clear: this purchase price is not a bargain for Berkshire, given Lubrizol’s results over the last five years. Any margin of safety then must lie solely in expected (and highly likely, one would presume) future performance. At minimum, I would think, Berkshire must expect revenues and margins to remain close to their 2010 performance, for at least the majority of the next decade.

Berkshire was not willing to offer LZ shareholders the option of Berkshire stock (as in the Burlington deal), so that should indicate Buffett’s thoughts on each’s relative value.

Longer term, LZ’s future revenues and earnings may face risks—if, e.g., 1) improved engine design increases drain intervals, 2) new vehicle purchases slow and stagnant, or 3) input costs (particularly petroleum) increase faster than expected.

Clearly, I’m missing some important piece of this puzzle.

Disclosure: I hold shares of Berkshire Hathaway.

“BECKY:  That’s one of many questions that have come in, but we also have questions that have come in about Moody’s. Achit in Arizona writes in, “In your FCIC interview, you spoke of the inherent advantages of a duopoly that Moody’s and S&P share. Why does Berkshire continue to reduce its interest in Moody’s? Is there too much headline risk” for you?

BUFFETT: Well, I think that duopoly is in somewhat more danger than it was simply because people are mad at the ratings agencies and the ratings agencies totally missed what was going on in the mortgage market and that was a huge, huge miss. I don’t think they were, you know–I think they were just wrong, like a lot of people were wrong about in thinking that housing prices couldn’t go down a lot, but they were rating agencies and they’ve gotten a lot of criticism for it and their business model is sensational when it’s a duopoly. I mean, I have no bargaining power. I’m going to see Moody’s in the week or I think or something about our ratings.

BECKY: Mm-hmm.

BUFFETT: And you know, I dress up and do everything I can to, you know, talk about my balance sheet. But they–they’re God in the ratings field and Standard & Poor’s, and I need their ratings. And if they tell me the bill is X, I pay that, and if they tell me the bill is X plus 10 percent, I pay that. You know, if Coca-Cola charges too much, you know, you may think about drinking Pepsi Cola, but in the rating agency business, you need those two. And if that–either people get so upset with them or whatever it may be, or Congress gets upset, that could disappear. It won’t disappear from natural reasons. I mean, it is a natural duopoly, just like–it’s a little different than Freddie and Fannie were, but they also had some specific advantage. Sometimes you find situations where you get a natural–well, you used to have that in the newspaper business. You had a natural monopoly in big cities. It wasn’t–it wasn’t illegal, it just worked out that way.

BECKY: Mm-hmm.

BUFFETT : And that’s what happened in ratings agencies. But it’s not as bullet-proof as it was. Although, I will say that…

BECKY: Does that explain why you’ve been selling?

BUFFETT: Well, we haven’t sold that aggressively.

BECKY: Mm-hmm.

BUFFETT: I mean, if you look at it during the course of 2010, we sold a very small amount of the–it looked to me that that threat was receding to some degree. But it’s different than it was five years ago…” [Emphasis added.]

[A couple years ago, I suggested that Moody's Structured Products Group (SPG) would find it difficult to match past peak revenues ($873m in 2007).  In their latest 10-K, 2010 revenues from the Structured Finance Group appear down 5% v. 2009, to $291m.

In the meantime though, revenues from their Corporate Finance Group have held strong, and increased 38% YOY in 2010, to $564m.  Income before tax (for the whole company) was $714m in 2010, compared to $730m in 2008.  Despite a substantial revenue decline in their largest business line from 2008 to 2010, income before tax (for the company as a whole) has held relatively steady, even with a tarnished reputation.  So Berkshire will hold.]

Disclosure: none.

But a copy of “A Brief Popular Account of all the Financial Panics and Commercial Revulsions in the United States, From 1690 to 1857: with a More Particular History of the Two Great Revulsions of 1837 and 1857″ found my hands in recent days. (Google eBook here)

Written at a time when the United States’ “business system” was laboring under “difficulties” (i.e., 1857), the author endeavors to uncover “the causes of financial revulsions” and distinguish them from financial panics, with the ultimate aim of “prevent[ing] the recurrence of similar periods of panic and disaster.”

Whereas a panic “is a pressure in the money market without adequate cause,” a revulsion “is pressure with adequate cause, and that cause invariably is a previous Destruction of Value” (1).

In other words, “a national Revulsion is a national pay day.  The nation has been drawing on the Future, and the Future dishonors the draft.  The forcing process is then applied, widespread ruin is the result, and long period of paralysis ensues.”

A simple insight and a memorable analogy–business transactions flourish or cease, largely based on the beliefs we hold about the future.  Most of the time, our beliefs imperceptibly wax and wane; of course, when they change in an instant, we write a book about it.

Regarding the revised estimates, Ken Peak, Contango’s Chairman and CEO, remarked:

“The downward reserve revision is an enormous personal disappointment. I know full well the complexities and numerous uncertainties of reserve estimation, especially early on in a field’s production history. Moreover, the impact of a downward revision is particularly acute when all the Company’s reserves are in essence concentrated in one reservoir. I have full confidence that our reserve estimates were prepared in a careful, conscientious manner and fully consistent with SEC and SPE guidelines. Nonetheless, it is right that the economic pain of this downward revision be shared, therefore, neither myself nor any Contango employee will receive a bonus or stock options for the fiscal year ending June 30, 2010.” (my emphasis added)

Lest the reader miss the economic impact of that statement, be it known that $2.47m of Peak’s $2.64m 2009 compensation derived from options and bonus pay. That’s an extreme pay cut–one of the largest self-inflicted I’ve ever seen (in terms of percentage).

Peak concluded with some commentary on the Gulf oil spill and its impact on Contango:

“The question on many minds these days is the impact of the Gulf of Mexico oil spill on the industry and in our case, Contango specifically. Obviously no one knows, but I will venture an opinion since it goes to the core of our business model and future. I am certain we will face increased regulatory and permitting costs and scrutiny. I believe we can deal with these challenges. I am certain we will face an increased emphasis on safety, and in particular, redundancy in “fail safes”. I welcome these new standards, but believe everything we are currently doing already meets a very high threshold of safety adherence. Hopefully, it is recognized and understood that no human endeavor is ever, and can never be made to be, absolutely, totally and flawlessly 100% fail safe.

“There are two areas that give me great concern. The first is the concept of unlimited environmental liability for a spill, or a limit so high that a debt-free company with an approximate $1.0 billion market cap like Contango is in essence, asked to “bet the Company” every time we drill a well. The move in recent days by some in Congress to retroactively change the law regarding environmental liability does not give me great confidence in our government. Nor do comments about “boots on throats”. The second area that causes great concern is the thought of going to jail for a judgment error or equipment failure – especially if the MMS approved the procedures that were being followed.

“There is at the moment, an enormous amount of understandable emotion and anger together with political populism spewing forth along with the Gulf of Mexico spill, but I believe, and hope, that once the spill is contained, that serious reflection and thought will be brought to bear on how the nation, coastal states in particular, and the livelihood of tens of thousands who depend on a vibrant offshore exploration industry, can beneficially coexist. Contango’s capital expenditure plans, even before this spill, were to “wait out” the upcoming hurricane season, so no adjustment to our capital expenditure plans is required.”

I’ll restrain any tendency to wax philosophical about contemporary political discourse and its relation to a nation’s moral fiber. Indeed pertinent facts still remain hidden from public view. What stands clear–the tone of our conversation today will shape the arc of an industry’s future.

Disclosure: no position

In light of these changed conditions, anglers want to know—would you still “throw it back” at these prices? Frankly, I would.

On first glance, today’s $1.2 per price may appear cheap. With about 60m shares outstanding, and 1m warrants with strikes near these prices, Mr. Market values Seanergy’s equity at ~$73m.

Yet, following the close of the MCS acquisition (i.e., June 3rd), Seanergy’s total assets (including now a fleet of twenty vessels) are approximately $730 million, its total debt approximately $430.8 million, and cash reserves near $84.5 million. These numbers suggest a book value (ex-goodwill) near $4.6 per share. This discount to book has led Seanergy’s management to conclude that today’s price represents “a great entry point.” And according to management’s recent CC remarks, the Restis family (i.e., Seanergy’s majority shareholders) thinks today’s stock price is cheap as well.

Apparently, angling for this bargain need not be a lonely endeavor.

Though in principle I appreciate the support of fellow anglers, my reasons for casting back here are threefold:

1) Seanergy operates in an industry with very weak business franchises (see Buffett’s discussion here). Barriers to entry (or, at least, capacity expansion) are low, with banks today still lending a substantial portion of the cost for new ship construction. Consequently, new supply looks abundant. As of April 2010, the total world drybulk fleet could carry 475.6m Dwt. 2010 should see an additional 109.5m Dwt increase in global drybulk capacity (that’s 23%). And we’ll see 104.3m Dwt more capacity in 2011, with 74.4m Dwt more in 2012 and beyond (according to Clarkson Research Services). As Seanergy plainly acknowledges, the current dry bulk order book is 60% of the world fleet, and most of this will come online in the next 2.5 years. Though I won’t make any predictions about dry bulk rates for 2011, it’s hard for me to see the global shipping trade increasing at a rate sufficient to soak up this oncoming supply.

2) On a liquidation basis, Seanergy’s (now twenty) ships are likely worth less than their current $430m in total debt, and after accounting for minority interests. Run your own back-of-the-envelope calculations on their aging fleet, but recent amendments to their outstanding credit agreement with Marfin Bank of Greece show that their leash is tethered.

3) Even though their current market cap to EBITDA ratio may appear cheap, the metric ignores their significant debt load, and assumes that today’s corporate debt levels will be available in perpetuity. Better always, in my lights, to value businesses based on their enterprise value to EBITDA (or better yet, enterprise value to “owner earnings”).

Let’s say Seanergy earns 48m-60m EBITDA for 2010. If you bought the whole company at today’s market price of ~$1.2 per share, you’d be paying $72m for the equity (given 60m shares out), taking on the $430m in debt, and getting $85m in cash (as of 6/3/10). Call it $417m in enterprise value. For me, that’s not an attractive price to buy the business as a whole, particularly in an industry where depreciation is real and significant industry headwinds loom ahead.

Disclosure: no position

One nibble this week was Seanergy Maritime Holdings Corp (SHIP). Having shown up on The Graham Investor’s NCAV screen, and having seen the substantial stake owned by Pine River Capital management, I took a closer look.

According to its recent prospectus, Seanergy is an “international company providing worldwide transportation of dry bulk commodities through our vessel-owning subsidiaries and Bulk Energy Transport (Holdings) Limited, or BET. Our existing fleet, including BET’s vessels, consists of one Handysize vessel, one Handymax vessel, two Supramax vessels, three Panamax vessels and four Capesize vessels. Our fleet carries a variety of dry bulk commodities, including coal, iron ore, and grains, as well as bauxite, phosphate, fertilizer and steel products.”

On many metrics—price to book, price to net current assets, and price to owners earnings—Seanergy looks stunningly cheap. With a “hard” book value (ex-goodwill) near $210 m, the current market price near $2.5 per share implies that the company is worth only $83m (given its 33.26m shares outstanding, as of 1/7/10).

Plausible reasons may be offered for this apparent discount: a) a short operating history (having only been public since 2008), b) a significant debt load (with $278m in long-term debt at 9/30/09), and c) general uncertainty about global shipping rates in the near term. While each is important, none would lead this analyst to immediately toss it back.

That is, until one notices their recent preliminary prospectus from Jan. 11, 2010, in which Seanergy proposes to sell up to $33.75m in common stock (and grant warrants to the underwriters), in order to “purchase a 2009-built Capesize vessel for $89.5m pursuant to the terms of a memorandum of agreement entered into on December 16, 2009 with an unrelated third party.”

Though the prospectus is only preliminary, and the pricing has not yet been set, if the offering priced at current levels (near $2.5 per share), nearly 13.5m shares would be sold, and the outstanding share count would increase by more than 40%.

In some respects, such behavior seems standard fare—acquisitions are made, cash is raised, and revenues are grown. Yet, for the investor, the only real interest is the effect of such decisions on (per-share) business value. And here the investor should be sorely disappointed.

Before the proposed offering, the shareholder is able to purchase a claim on $6.30 per share in hard assets ($210m / 33.26m shares outstanding) at a nearly 60% discount (given a market cap of $83m). After the offering, that same shareholder—after having seen $33.75m added in equity to buy a $89m asset, with the remainder financed with debt—would have a claim on $244m in hard assets. But, given the increase in shares outstanding (to near 47m), that claim is now against only $5.2 per share in hard assets.

In other words, the buyer of shares today is likely to see the per-share value of his claim on Seanergy’s assets fall by nearly 20%, if the proposed offering goes through near today’s market prices. Of course, were Seanergy’s price to fall further, the damage to existing shareholders could be greater.

Most simply, there is only one way that the offering makes sense for a rational capital allocator–that is, if the desired Capesize vessel can be purchased at a greater discount than the current discount of Seanergy’s shares. Relative to Seanergy’s “hard” book value, its shares are currently trading at a greater than 60% discount. Even if Seanergy’s current “hard” book value overstates the value of its current ships by 50%, today’s share price would still represent a significant (perhaps 20%) discount to this lower figure.

So does Seanergy’s new proposed purchase meet this test? Is the new Capesize available at a 20% discount to its fair value? Using the proxy’s most recent estimates, a new Capesize was selling for about $58m in September 2009 (p. 126). Paying $89m for such a vessel hardly looks like a 20% discount.

Better throw this fish back.

Disclosure: None

In the midst of the storm, Mariusz Skonieczny of Classic Value Investors offers the interested observer a map—Why Are We So Clueless about the Stock Market? (Investment Publishing, 2009)

Written with the beginning investor in mind, Skonieczny provides a compact, readable introduction that teaches how to analyze financial statements, value businesses, discern competitive advantages, and scout for bargains in the stock market. Skonieczny also puts his tools to the test by surveying four excellent businesses with durable competitive advantages—Burlington Northern Santa Fe, Thor Industries, Wells Fargo, and Moody’s. These case studies alone are worth the price of admission.

Throughout, I appreciated Skonieczny’s persistent attentiveness to economic moats and competitive advantages. Following Pat Dorsey’s The Little Book That Builds Wealth (Wiley, 2008), economic moats derive primarily from four sources—a) intangible assets, like brands, patents, and regulatory licenses, b) high switching costs, like that enjoyed by Alcon’s ophthalmological surgery equipment, c) network effects, enjoyed by services like Match.com, and d) cost advantages. While these four competitive advantages are rarely quantified on balance sheets, they provide a consistent tailwind for future business returns, particularly when measured over years and decades.

Of course, those same advantages—once fully utilized and recognized by the market—may encourage industry leaders into sloth. And sometimes the sleepy stumble and fall.

If I had one quibble with Skonieczny, it would be with his rather sanguine analysis of Moody’s. As we’ve worried about here and here, despite Moody’s regulatory imprimatur, network effects, and switching costs, their future looks much less certain than anytime since the 1930s. Whether too sleepy or greedy, Moody’s foray over the last decade into all manner of Wall Street’s structured financial products has tarnished its reputation, and perhaps more importantly, its cash flows. As late as 2007, structured finance ratings provided near half of Moody’s Investor Service’s revenues. And until the structured finance markets return (and assuming that they will), Moody’s will not be able to grow their earnings at the 10-20% that they—in the past—easily have.

All told, I enjoyed Why Are We So Clueless about the Stock Market? and would readily introduce it to family and friends interested in thinking about stocks as shares of a business.

Disclosure: None

We continue in that vein today by profiling Tucows, Inc. (TCX), an ICANN-accredited internet domain registrar based in Toronto that manages email services and over nine million web domains. Through its subsidiary Butterscotch.com, it also owns one of the oldest and most popular software download sites on the Internet. At present, its principal shareholders include: Lacuna, LLC, which controls 17.7% of outstanding shares (as of 3/23/09), Diker GP LLC (13.7%), and Fertilemind Capital Fund I, LP (5.7%).

About two-thirds of Tucows’ revenue derives from its wholesale domain registration services, being the third largest ICANN-accredited registrar in the world and the largest publicly traded. And like other domain registry servicers (e.g., Network Solutions, GoDaddy), its business model is characterized by non-refundable, up-front payments, which generate predictable, positive operating cash flows. More specifically, Tucows receives payment for the annual registration fee prior to providing the full cost of the service, yet it is required to book those payments and costs incrementally. Looking at its balance sheet, one sees what—at first glance—may appear to be a highly-levered, capital-intensive business with nearly $97 million in assets and $75 million in liabilities. Yet, the bulk of these assets and liabilities pertain to prepaid fees and deferred revenues for their domain registry business. In truth then, Tucows is a cash-rich and largely unlevered business that fills its checking account faster than its earnings statement would indicate. In a way, its revenue resembles an insurance premium—non-refundable, and paid up-front—and enables Tucows to keep its cost of capital very low and perhaps even negative.

However, it is not only the balance sheet that masks Tucows’ virtues. In 2008, Tucows took initial steps to divest non-strategic assets and concentrate energies on its most profitable businesses. This process has complicated its cash flow statements and masked its significant free cash flow growth. For example, in 2006, depreciation and amortization charges of $3.9 million were less than capital expenditures ($4.6 million); in 2008, depreciation and amortization charges of $4.8 million far exceeded capex ($2.1 million). Because Tucows has significant amortization expenses—deriving from the intangible assets of previous acquisitions (i.e., customer relationships)—it has far more cash coming into the company today than its reported earnings reveal.

Lastly, Tucows has raised more cash in the last year by liquidating its $7.5 million equity stake in Afilias and a portion of its domain name portfolio. In their second quarter results (coming out in mid-August), Tucows will book a $2 million pre-tax gain on a portion of its Afilias stake; an additional $2 million pre-tax gain will also follow later this year.

Perhaps most interesting though is where all that cash is likely to go. In the last year, Tucows has used some cash to pay down its long term debt, repurchased 4.2 million shares (about 6% of those outstanding) in a “Dutch Auction” tender offer in March 2009, and repurchased an additional 1.1 million shares in a second “Dutch Auction” tender offer in July 2009. And to date, Tucows has ample room remaining in its $10 million stock repurchase program. Though the future capital allocation decisions are difficult to predict, the chains of habit are not easily tossed aside.

All told, Tucows strikes me as a relatively low margin business with low (and perhaps negative) capital costs that has deployed its retained earnings profitably for shareholders in recent years. Though GoDaddy is the dominant player in the sector, Tucows has added customers and concentrated its business lines. If Tucows continues to divest its non-strategic assets and contain its costs, I would not be surprised to see them earn more than $7 million this year ($4.5 million from operations and $2.5 from after-tax sale of investments). With a market cap of $29 million (as of 7/30/09), management and the Board should have an opportunity to buy back shares quite cheaply.

That is, unless enterprising investors find it first.

Disclosure: I, or persons whose accounts I manage, own shares of Tucows at the time of this writing.

Over at Berkshire, book value per value increased 20.3%, to $7745. Since Warren and Charlie took up textiles, book value has grown from $19 to $7,745, or at a rate of 23.6% compounded annually. Look through earnings came in at $604 million. Despite all of Warren’s warnings, Berkshire’s performance has consistently been able to outpace his stated goal—to grow intrinsic value at 15% per annum.*

On Acquisitions

In this year’s letter, Buffett bears all, as he discloses his most exhiliarating activity at Berkshire—“the acquisition of a business with excellent economic characteristics and a management that we like, trust and admire.” And Buffett knows he is not alone, for “in the past, [he’s] observed that many acquisition-hungry managers were apparently mesmerized by their childhood reading of the story about the frog-kissing princess. Remembering her success, they pay dearly for the right to kiss corporate toads, expecting wondrous transfigurations. Initially, disappointing results only deepen their desire to round up new toads.”

What sets Buffett apart from other spirited suitors is his patience. And 1992 saw his patience rewarded, purchasing 82% of Central States Indemnity, “an insurer that makes monthly payments for credit-card holders who are unable themselves to pay because they have become disabled or unemployed.” A family owned business, Central States is based in Omaha and has annual premiums are about $90 million and profits about $10 million.

On Insurance

By 1992, the Berkshire shareholder is surely accustomed to hearing the Chairman warn that future returns will lag those of the past, primarily because its swelling capital base demands larger businesses to produce significant investment returns. In order to grow “look-through” earnings by 15%, or $100 million, Berkshire would likely have to lay out at least a billion. Yet, the amount of excellent businesses that could absorb such an investment is relatively small.

One viable candidate though is super-catastrophe insurance. Looking ahead, Buffett can see that Berkshire’s future earnings growth will increasingly depend on its insurance businesses, and as usual, he wants its shareholders to calibrate appropriate expectations beforehand. In short, super-cat insurance—though likely profitable over the long term—may produce abysmal results for any single year. Pricing in particular is difficult to determine, for “catastrophe insurers can’t simply extrapolate past experience. If there is truly “global warming,” for example, the odds [for potential losses] would shift, since tiny changes in atmospheric conditions can produce momentous changes in weather patterns.” Even worse, occasionally, the unthinkable happens. “Who would have guessed, for example, that a major earthquake could occur in Charleston, S.C.? (It struck in 1886, registered an estimated 6.6 on the Richter scale, and caused 60 deaths.) And who could have imagined that our country’s most serious quake would occur at New Madrid, Missouri, which suffered an estimated 8.7 shocker in 1812.”

“Furthermore, in recent years there has been a mushrooming of population and insured values in U.S. coastal areas that are particularly vulnerable to hurricanes, the number one creator of super-cats. A hurricane that caused x dollars of damage 20 years ago could easily cost 10x now.”

Pricing for the unexpected and adjusting for lifestyle changes represent two prongs of Berkshire’s strategy. The last—conservative accounting. “Rather than recording our super-cat premiums on a pro-rata basis over the life of a given policy, we defer recognition of revenue until a loss occurs or until the policy expires… because the likelihood of super-cats causing us losses is particularly great toward the end of the year. It is then that weather tends to kick up: Of the ten largest insured losses in U.S. history, nine occurred in the last half of the year. In addition, policies that are not triggered by a first event are unlikely, by their very terms, to cause us losses until late in the year.”

“The bottom-line effect of our accounting procedure for super-cats is this: Large losses may be reported in any quarter of the year, but significant profits will only be reported in the fourth quarter.”

On Buying General Dynamics

Of course, all the work in writing reinsurance could be for naught if the capital it provides were not profitably deployed. In common stocks, Berkshire acquired a large new position in General Dynamics. Initially Buffett purchased the shares to take advantage of an arbitrage opportunity (General Dynamics was repurchasing 30% of its shares via a Dutch tender), but the more he uncovered about the business and the CEO Bill Anders, the more impressed he was: “Bill had a clearly articulated and rational strategy; he had been focused and imbued with a sense of urgency in carrying it out; and the results were truly remarkable.”

So Buffett dropped the thoughts of arbitrage and “decided that Berkshire should become a long-term investor with Bill. We were helped in gaining a large position by the fact that a tender greatly swells the volume of trading in a stock. In a one-month period, we were able to purchase 14% of the General Dynamics shares that remained outstanding after the tender was completed.” [NB--In less than two years, Mr. Market re-appraised Berkshire’s stake at more than four times its 1992 price.]

On Buying Growth or Value

As always, Buffett uses his annual letter as a lectern to dispense his investing lesson for the day. And 1992 saw him distill wisdom from contemporary financial jargon. To both his fellow investment professionals who pursue “value” stocks, and those seeking “growth,” Buffett notes that John Burr Williams, some 50 years ago, set forth the proper equation of value, as “the value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.” Stated so, it is clear that investing—no matter one’s emphasis—will be most successful insofar as one can determine future cash flows and the remaining life of a given asset.

Growth “is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.” And what is investing except the seeking of value sufficient to justify the price paid? “Value investing” then is redundant.

Yet, “whether appropriate or not, the term “value investing” is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value” purchase.”

The investor then should not settle comfortably in this jargon, for growth projections can soar to the moon, and discounted assets can still be priced too dear. Focus on cash flows, while keeping in mind, that “the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find: Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.”

On Health Care Liabilities

Even among smart and hard-working stock analysts, one can find negligent disregard for off-balance sheet liabilities—pensions, health care benefits, SIVs, etc. One only needs to look to today’s Washington to see the difficulties of reserving money for tomorrow’s health care.

Thinking as an insurer, Buffett notes that “no CEO would have dreamed of going to his board with the proposition that his company become an insurer of uncapped post-retirement health benefits that other corporations chose to install. A CEO didn’t need to be a medical expert to know that lengthening life expectancies and soaring health costs would guarantee an insurer a financial battering from such a business.” Given the rate and cost of health care innovations, population demographics, and the United States’ love for perceptions of egalitarianism, it is indubitable that health care costs relative to GDP will be much higher than they are today. To insure against this eventuality would require more chutzpah than any insurer would care to muster.

Yet, “many a manager blithely committed his own company to a self-insurance plan embodying precisely the same promises – and thereby doomed his shareholders to suffer the inevitable consequences. In health-care, open-ended promises have created open-ended liabilities that in a few cases loom so large as to threaten the global competitiveness of major American industries.”

And Buffett is not afraid to place blame, for “the reason for this reckless behavior was that accounting rules did not, for so long, require the booking of post-retirement health costs as they were incurred. Instead, the rules allowed cash-basis accounting, which vastly understated the liabilities that were building up. In effect, the attitude of both managements and their accountants toward these liabilities was “out-of-sight, out-of-mind.”

“Managers thinking about accounting issues should never forget one of Abraham Lincoln’s favorite riddles: “How many legs does a dog have if you call his tail a leg?” The answer: “Four, because calling a tail a leg does not make it a leg.” It behooves managers to remember that Abe’s right even if an auditor is willing to certify that the tail is a leg.”

Conclusion

All told, 1992 was a year with much to say. Beyond these lessons, Buffett highlights the advantages of purchasing securities in the secondary market (rather than initial offerings), the lack of correlation between high corporate overhead and business performance, and the true cost of stock options. And last but not least, learn from Mr. Buffett’s mistake; be not too incautious with your 89 year old employees. Some, like Mrs. B., just may rekindle the fire to compete. At 99, Buffett finally got her signature on a non-compete.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

* Of course, growth in book value and intrinsic value often diverge significantly, and in extreme cases, show no correlation. In assessing Buffett’s performance in 1992, we feel comfortable taking him at his word: that Berkshire’s book value is a useful, albeit conservative, proxy for valuing the business.

[In more recent years, this same assessment would look increasingly foolish, as one of the largest components of Berkshire’s intrinsic value today is the value of its insurance float, which has grown significantly, relative to Berkshire’s book value, since 1992. In 1992, Berkshire had 2.3 billion in float vs. about 7.5 billion in equity; in 2008, it was 58 billion in float vs. 109 billion.]

In the recent 13D filing for Peerless Systems Corporation (PRLS), its Chairman Timothy Brog expresses some frustration with Highbury Financial’s (HBRF) current Board and management:

Gentleman,

Peerless Systems Corporation owns 1,197,673 shares of Highbury Financial Inc. (“Highbury” or “HBRF”) common stock (“Common Stock”) and 1,525,241 warrants (“Warrants”) exercisable into a like number of shares of Common Stock.  As the holder of these securities, Peerless is one of the largest shareholders of Common Stock and together with our warrant ownership (assuming the exercise thereof), we are the largest shareholder of Highbury.

As you are aware a meeting took place in Chicago on July 1st (the “Chicago Meeting”) between the largest four non-management shareholders of Highbury (in the aggregate such shareholders own approximately 60% of the outstanding Common Stock) on the one hand, and management and the Board, on the other hand…  We have been patient to date, but we are disappointed that after almost three weeks since the Chicago Meeting you have continued to ignore your shareholders.  With no response, our patience has run out and our resolve is strong to take ALL available actions that a shareholder in HBRF possesses.

The audacity and self-serving behavior of corporate board of directors has always amazed us.  Almost every time we interact with a new board we hope for the best and prepare for the worst.  One of our favorite parts of dealing with boards is hearing them state that they always act in the best interest of their shareholders, they do not need the money from board fees and they have no desire to serve on a board if they no longer have the support of shareholders.  However almost invariably, shortly after making such statements, they take all possible measures to entrench themselves, waste corporate assets to achieve such purpose and hang on to their positions as board members for dear life.  Their attitude is “Damn the Shareholders, Full Speed Ahead.”

You gentlemen, the Board of Directors of Highbury, did not disappoint us.

Since Messrs. Cameron, Ammidon, Leary and Riordan refused to attend the Chicago Meeting they may not be aware of what transpired.   Several shareholders traveled thousands of miles to attend the Chicago Meeting, but other than Richard Foote no other Director attended even a portion of the 3½ hour meeting.  Since Bruce Cameron and his pals Messrs. Ammidon, Riordan and Leary did not have the “testicular fortitude” to participate in the Chicago Meeting in person, nor attempt to attend all or even a portion of it telephonically, nor even bother to explain their absence to shareholders, let us make it clear to each of you what you missed.  We stated in the conclusion of the meeting that management of Highbury should immediately resign and the Board should be reconstituted to include a representative of each of the five largest shareholders.  The other three large shareholders at the meeting, who, again, together with Peerless own in the aggregate approximately 60% of Highbury’s outstanding common stock (for those directors who want to disregard this fact, that is more than a MAJORITY), each individually reached the same conclusion and stated so…